THE CASE FOR MULTIPLE SYSTEMS
Our original philosophy about trading systems has changed considerably over the last year or two. We once believed that the best trading results were obtained by employing one system that traded all markets long and short. Then we spent years of research developing such a system. We produced an ADX based system that traded all markets long and short with identical parameters and showed outstanding test results. The system was then traded with millions of dollars and performed quite well for several years. Then it abruptly started producing losses rather than profits. Our research into the causes of the decline in performance led us to conclude that it was not realistic to expect one system to be able to perform well in all markets under all market conditions.

Like generations of traders before us we had somehow assumed that the answer to good trading could be found in creating that one great system. Looking back now we wonder why we ever made such an illogical assumption. No one system can be expected to perform well under all conditions. In addition, in order to perform well across a wide range of markets the system often has to compromise outstanding performance in particular markets. The consequence of this approach is to employ a system that barely works in many markets yet isn't outstanding in any. Typical "do all" systems average about 30% to 40% winning trades and produce long and severe drawdowns that eventually become unsustainable.

Consider now the merits of multiple systems: We would obviously start with a trend following system for the big trends. But we must also have a system that works well when there are no trends. We would trade systems where the profits are taken at target points and have systems that patiently let the profits run. We could design systems for long only and short only. We could have systems with tight stops and systems with wide stops. When we were trading we would have long term, intermediate term and short term systems all running at the same time. We could even use systems that day trade.

Why do we try to make one system do everything? What's the point? Why not design systems for very specific purposes and specific markets? Once a system's purpose is clearly and precisely defined it becomes much easier to create very sound logic for the system. Each part falls into place precisely without needing to compromise.

Ten years ago it might have been operationally impractical to attempt to operate multiple systems. But with today's sophisticated technology any trader with a computer can easily run as many systems as they have capital to support.

Knowledgeable traders have long been aware of the advantages of diversification among markets. Now a few innovative professionals are also reaping the rewards of diversification among systems. In fact a few very large and well known CTAs are currently trading more than a hundred systems at a time. The idea makes good sense.

However, we believe that for the multiple system approach to work as intended the systems need to be carefully matched to avoid duplication and overlapping trades. For example, when we designed the "25 X 25" and "Big Dipper" bond systems, we were careful to design them so they are unlikely to enter the market at the same time because they both trade on an intermediate time frame. The "Little Dipper" was designed to trade on a very short term time frame.Because the systems were designed for a very specific purpose, buying a strong bond market on dips, we were able to achieve very impressive historical results using simple logic. If we had to worry about trading the short side of the corn market with the same system, the problems in developing such a system would have compounded and we would not have been able to produce the same results.

Now many system traders are going to argue that single purpose systems are prone to optimization. This may well be true, but it could also be argued that single purpose systems can produce excellent results without the need for optimization, whereas multi-market multipurpose systems are so difficult to produce that the designers must resort to optimization to obtain acceptable historical results.

One of the problems we faced with our long term trend following system was low trading frequency which tended to make our performance erratic and prone to peaks and valleys. In order to take advantage of our statistical "edge" we might have to complete thirty or forty trades. Using along term trend following system it could easily take a year or two to generate this many trades even with multiple markets. However a combination of good systems should produce a more statistical meaningful number of trades over a much shorter time period. Therefore the trading results should be noticeably more consistent and dependable. Ask yourself: Would you rather be trading one multi purpose trend following system with a low percentage of winners or trading several high percentage multiple systems: Systems designed to follow trends, buy and sell corrections, trade within a range, profit from small and large trends, and trade long and short with equal accuracy. We believe that a combination of properly designed systems, each with a specific purpose, should substantially out perform conventional "do everything" systems.
 

SOME ASSEMBLY REQUIRED
Just as we did in the previous Bulletin, we want to continue passing along ideas for ingredients of trading systems. But before we do that we thought it might be a good idea to establish a basic framework and background information so that we can communicate our trading ideas in the proper context.

We view the process of creating a system much like Henry Ford viewed the building of automobiles. We start with interchangeable parts and then assemble them step by step much like an assembly line. When we discover a part of a system that performs a particular function especially well, we save it and store it in our "parts warehouse" so that we can take it out and use it whenever we need a part to perform that particular function. Each individual part of the system should be well tested and proven capable of performing its required role in a logical fashion.

Now lets assume that these parts are all sitting around in our system parts warehouse. When we want to build a new trading system we can't just start throwing various parts together randomly. We need a framework and the parts need to be assembled onto the framework in the correct order. Here is an outline of how we view this assembly process.

STEP I: Market Selection. We need to be able to select the best markets to trade at any given time. We want to focus our trading attention on those markets that offer a high level of liquidity and a high level of potential profitability. Good markets will have a combination of high trading volume, clear direction, and enough volatility to make potential trading profits worth the risk and expense of trading.

STEP II: System Selection. We want to have a wide choice of systems and we need to know how to select the right system for the current market conditions. We want to have long term, short term and intermediate term systems to choose from. We also want to have trend following and counter trend systems available. We want to be capable of buying dips or following strength. We need enough systems in our systems inventory to take advantage of whatever market conditions currently prevail and be able to change systems promptly if those conditions should change.

STEP III: Entry selection. We view the entry process as having three logical functions that will require us to assemble three or more important parts from our system parts warehouse.

A. Direction identifiers. Tell us if the market we have selected is going up, down or sideways.

B. Setups. Alert us when a good trading opportunity is getting near.

C. Triggers. Signal us that the best time to enter the trade is right now.

STEP IV: Exit Selection. We also view the exit process as consisting of several logical functions that will require us to assemble even more parts from our warehouse.

A. Risk control exits. Usually some fixed dollar amount or "worst case" stop order is necessary to clearly limit our maximum loss and protect our trading capital.

B. Trailing exits. These useful exits gradually move in our favor as the market moves in our favor and reduce our initial risk level so that our "worst case" stops are no longer exposed. If the market moves far enough some profits are eventually locked in.

C. Trend reversal exits. These exits signal us when there is an indication that the direction may have changed and our logic for entering the trade is no longer valid.

D. Profit protection exits. Once the trade has become sufficiently profitable, these logical exits keep our profitable trades from turning into losers.

E. Profit taking exits. Large profits eventually must be taken. These critical exits try to take profits as near as possible to the point of maximum potential profit.

There you have our philosophy about the process of building trading systems. Now when we offer Traders Club members an ingredient of a system we will also suggest where we think it fits into our recommended framework for assembling a system. This should help everyone to get the most value out of the ideas we will be presenting.

For example in our last bulletin we offered the "Chandelier Exit". We suggested this versatile exit as one of our first ideas because it fits so well into all of the exit categories and it has been thoroughly researched. It can be used as a trailing exit, a risk control exit, a trend reversal exit, and a profit taking exit. If you were building a system that could have only one exit strategy, the Chandelier Exit would be a good choice. Other exits can perhaps do a better job of one particular task or another but few of them can do so many tasks so well as the Chandelier Exit.

In fact, we recommend that you use the Chandelier Exit as your basic benchmark for all of your exits. Start with it and then see if you can improve on the results by employing multiple exits which have more specific goals.


SYSTEM DESIGNERS TOOL BOX

The Volatility Entry

CATEGORY III C. -- ENTRY TRIGGER

This simple entry is generally one of the most reliable entry triggers for trend following systems. It's always a good first try when you are looking for a trend following trigger that produces better than random results. It is usually implemented by adding a percentage of the Average True Range to the close of the previous bar or to the open of the current bar.

For example we could design a simple but effective entry statement that says: "Buy when the price reaches the previous days close plus .70 of the 20 day Average True Range." (The .70 value is just an example, not a recommendation. The number of days to use in calculating ATR should usually be set at 20 or more or else the entry trigger can become too sensitive due to brief periods of unusually low volatility.)

This entry trigger seems to be more reliable than most triggers because it would require that prices make a strong directional move precisely as we are entering the market. Of course we wouldn't be entering at the cheapest price but we would be entering after a move that showed the market definitely had confirmed its direction. We would have to sacrifice some potential profitability (buying cheaper) for the higher reliability of getting into the market only when our selected market is moving strongly in the direction we expect it to.

The most common application of this entry is to measure from the previous close but we have a slight preference for applying it from the open.. We find that moves from the open tell us a lot about what the market is likely to do over the short run. You should always test it both ways. There are probably many other ways of applying this entry trigger (from the previous day's high or low for example) but we haven't had the time to explore all the possibilities.

Combine the Volatility Trigger with the Chandelier Exit and you have the basic ingredients of a primitive trend following system. As primitive as this system might seem it can often serve as a useful benchmark. Plug in your favorite values for the ingredients and try it on a market or two. Then use these results as a benchmark and see if you can improve the results with other ideas and other systems.

This will give you some way of measuring your progress and a method of evaluating other ideas you come up with. How does your latest idea compare with the simple Volatility/Chandelier benchmark?

ADX HAS IT'S LIMITATIONS:

(I'm referring to Welles Wilders Average Directional Index in case you are a "newbie".) After many years of extolling the virtues of the ADX in articles and lectures all over the world I have become closely associated with this indicator. That's fine with me and I don't mind being considered the resident expert on ADX. It is an excellent measure of trendiness and a good indicator to be linked with.

However, I think it is a mistake to try and over work or become too dependent on any one indicator. If you were going to build a house you would need more than one tool and you wouldn't try to do it with just a hammer. The same is true of building systems. The ADX can be a very valuable tool if used correctly but it has some major shortcomings that everyone should be aware of: We all know that the ADX is slow. This is because of all the smoothing in the formula. The basic ingredients are smoothed and then the results are smoothed again. For example I think it takes more than 30 bars of data to calculate a 14 bar ADX. This smoothing makes the ADX slow but there is an even greater problem than just the speed of the indicator. The logic of measuring directional movement makes the ADX very reliable at certain times and very unreliable at other times.

A rising ADX is a reliable indication of a trend when there has been an extended sideways period before the trend gets started. Before all the high tech computer mumbo jumbo we used to simply refer to this sideways period as a "basing pattern". The ADX is most effective when it begins to rise from a low level (low = 15 or less). This low level on the ADX indicates that there has been a basing pattern for a while. This interpretation is contradictory to those users of the ADX who want to see the ADX cross above a specified threshold (usually 20 or 25) to indicate that a trend is underway. This technique would make the ADX even slower and means you would be confirming a trend and entering your trade long after the basing pattern was broken. But even if you were late due to your method of interpreting the ADX, following the ADX after a base pattern is still quite reliable. The potential problem I want to bring to your attention in this article is the action of the ADX after major peaks and valleys.

The logic of the ADX is best visualized as measuring directional movement over a moving window of data on a bar chart. If we have sideways data in the window followed by recent trending data (lets think of rising prices but it could be the reverse), the rising prices would show directional movement relative to the sideways data at the beginning of our window. The ADX would promptly rise and call our attention to the fact that there is now a direction in prices that should continue for a while.

However, if the prices rise for an extended period and then begin to fall sharply (a typical scenario) we now have a window of data that shows rising prices followed immediately by falling prices. The ADX formula measures the rising prices in the window and compares them with the declining prices in the window. Because the two trends are about equal they cancel each other and the ADX does not detect any net directional movement. The ADX now begins to decline indicating that it is finding no net directional movement in the period measured by the window.

As the window moves forward, eventually the older rising price data falls outside the back of the window so that the window now contains only the more recent downward price movement. The ADX suddenly begins to rise rapidly because the data window at this point contains only one trend. The problem with this new signal is that the downward trend in prices has been underway for quite some time and only now has the ADX finally begun to rise. This is obviously not a good point to be entering a trade to the short side. We are probably nearer the end of the trend than the beginning.

Remember that the ADX works best after a basing period and is unreliable after a "V" bottom or top.
That"s all for now. I'll continue this discussion of the ADX in our next bulletin which should be out very soon.

Remember to visit the website often and participate in our FORUM discussions. Post anything you like that may be of interest to fellow club members. Also please feel free to forward this bulletin to a friend and invite them to visit our web site at http://traderclub.com

Contradictions in using ADX:
In our last bulletin we described how the ADX works best when a move develops out of a basing pattern. Someone sent us a very courteous email questioning this strategy and reminded us of our "25 X 25"Bond system where we want the ADX to be above 20 before looking for an entry. He commented that by the time the ADX gets to 20 any move out of a base pattern may be over. He is absolutely right and I can see how there may appear to be some confusion on how the ADX should be applied. But there really isn't any contradiction if you understand that what we are trying to do with the ADX is very different in the two examples.

In the "25 X 25"strategy the ADX is used as an important "setup"condition that tells us when the trend is strong enough that we can confidently buy on weakness. However, when we describe the basing pattern strategy we are using the ADX as the actual entry trigger to buy on strength. There is a big difference in the buy on strength and buy on weakness strategies. In the basing pattern strategy a low level of the ADX is preferred because the rise in the ADX is the trigger. If the ADX is at 12 and starts rising we very well could miss the majority of the move if we waited for it to reach 20. With the ADX already at 20 or higher it might only be safe to buy on dips and of course that is exactly what the "25 X 25"bond strategy does.

To sum things up: there is no contradiction. To catch a move out of a base you should enter as soon as the ADX starts rising. Just compare today's ADX with yesterday's ADX and the faster it is rising the better. At this point the the lower the level of the ADX the better because we are buying on strength and the ADX is our entry trigger.

System Results Update

By the way, our bond strategies have been making lots of money this year. Hope you are all trading them with real money. Back in February I had lots of critics calling and asking why we were offering long only bond systems when bonds were at 115 and that had to be the top. They said that they couldn't possibly go much higher than that and our long only results could not hold up in real trading. Now that the bonds are over 130 I am glad that we have the Serendipity system that does trade the short side because I suspect that we really are near the top. (Doesn't take a genius to make a dumb statement like that. I apologize.)

The Big Dipper system has been long since July and has huge open profits even after having to be rolled forward from the September contract into December. The "25 X 25"system is not doing bad either. When is the last time you had a free system make that much money for you? And last but not least, lets not forget the "Little Dipper". According to my recollection the last seven trades were all winners and it could be more because I can't remember the last loser. Not too bad for out of sample trading results. REMEMBER: PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE SUCCESS. I'm not just saying that because I have to. I really believe it and so should you. The bull market in bonds has made us look smarter than we really are. Bull markets do that.

Ideas needed:
I would like to remind members that they are encouraged to share their thoughts and ideas with the Club. Don't be bashful. This is your club and I want to hear from you either privately via email or publicly on our FORUM page. I don't want to be the only one voicing opinions here. I'll be the first to admit that I don't have all the answers and I don't aspire to "guru"status. We've got too many of those already.

Check out our FORUM page and post something, even if its a simple question, comment or observation. We don't need or expect any Pulitzer prize winning narratives. Just be relaxed and positive and try not to say anything that you might regret.

DEALING WITH EXCESSIVE VOLATILITY:

The recent volatility in the stocks, bonds, and currencies have created opportunities and problems for traders. Brief periods of excessive volatility are nothing new and we all need to have a high volatility contingency plan that allows us to deal with these conditions in a rational and objective manner.

You never want to just skip trades arbitrarily. This is a bad idea and can quickly become a costly habit. I have a rule of thumb that I try to apply in cases of high volatility that helps me to decide if I should enter a trade in a high volatility situation. I should warn you that this rule sometimes saves me money and it sometimes costs me big profitable trades. The primary benefit of the rule is that it is
objective and disciplined. The rule keeps me from just guessing and agonizing over what to do in situations where the volatility is obviously extreme. The rule has some inherent logic that helps me to quantify "extreme" volatility on a system by system and market by market basis.

The rule is that if the recent daily range is greater than the money management stop you are using, you don't do the trade. The logic is that our money management stops should be outside the range of what normally happens in one day. To have stops closer than that is to be inside the "noise level" where you can get randomly stopped out for no good reason. Once the market settles down to where the range between the high and low is less than the amount of your stop you could then enter the trade and safely place your stop.

Now let me give you a specific example. We just took a quick but big loss on a Yen trade today and it is now set up for a new trade tomorrow. The range over the last day or two, as we all know, has been far beyond normal, several times more than our protective stop loss. The trade for tomorrow should be skipped because of the volatility rule described above. If you like, the trade can be entered at a later date when the average true range is less than our stop.

This volatility rule applies to all systems and markets. It does not come into play very often and it is not something we just made up for the Yen. I have found it to be a valuable rule that I have used for years to limit my exposure in times of excessive volatility.

Please keep in mind that high volatility is an opportunity for unusually large profits as well as losses and if you skip a big winner you will certainly regret it. For those with more than adequate capital an alternative solution is to reduce the position size and arbitrarily change the money management stop to a much bigger number on a temporary basis. If you can afford losses of this size this might be a better solution because you would avoid being stopped out needlessly and you would still be able to participate in the big winners. Based on past experience I would say that as a minimum a stop of about two recent average true ranges would be required. Obviously this would be a huge dollar amount to be risking in Yen or S&Ps right now